BERLIN, March 3 (Reuters) - Heavily dependent on Russian gas and closer to Moscow than any other leading western nation, Germany faces a major policy dilemma as the Ukraine crisis descends into a Cold War-style confrontation of tit-for-tat threats and ultimatums.

For weeks, Chancellor Angela Merkel and her three-month old coalition government have gone out of their way to avoid antagonising Vladimir Putin, remaining measured even as Washington and other capitals ratcheted up the rhetoric.

The hope in Berlin was that an even-handed public stance and a bit of old-fashioned shuttle diplomacy could reduce the risks of all-out conflict with the Russian president.

German Foreign Minister Frank-Walter Steinmeier, a protege of former chancellor and Putin friend Gerhard Schroeder, has travelled to Moscow and Washington to urge restraint.

Merkel has stayed in almost daily phone contact with Putin as the crisis has deepened.

Two weeks ago she lobbied hard to win Kremlin backing for a deal mediated by Germany, France and Poland to resolve the standoff in Kiev, only to see that crumble within 24 hours when Ukraine President Viktor Yanukovich was deposed and fled the country.

On Sunday, Merkel's office said she had won Putin's support for the launch of a fact-finding mission to restart a political dialogue with Russia.

But the events of the past days - Putin seeking and winning parliamentary approval for an invasion of Ukraine and threats from the United States to "go to the hilt" to isolate Russia - have exposed the limits of Berlin's soft-power strategy.

They may also force Merkel and her coalition partner the Social Democrats (SPD), long advocates of engagement with Russia, into some difficult choices at a time when Berlin has promised its partners a more activist foreign policy.

"Germany is very concerned about its relations with Russia. There are the economic ties, but this is also about geopolitics - the idea in Berlin that Russia must be included," said Ulrich Speck, a visiting scholar at Carnegie Europe. "The biggest threat from Germany's perspective is a new Cold War."

CLOSE TIES

Developments on the ground have forced the German government to step up its rhetoric in recent days. Merkel accused Russia in a press release on Sunday evening of violating human rights and international law with its actions in Crimea.

But behind the scenes, Berlin remains desperate to avoid a confrontation with Russia that could have a long-term impact on relations with a country it continues to view as a vital strategic partner.

Germany receives close to 40 percent of its gas and 35 percent of its oil from Russia - well above the European average. German corporate investments in Russia totalled $22 billion as of October 2013 and German firms own stakes in roughly 6,100 Russian companies.

Some 200,000 Russian citizens and 2.5 million ethnic Germans from the former Soviet Union live in Germany. Putin himself spent five years in Dresden as a KGB agent in the 1980s, speaks fluent German and reads the German press.

At the start of a meeting with Steinmeier last month, the Russian president startled his visitor with a diatribe about how his country was being unfairly criticised in the German media, according to sources familiar with the exchange.

Geography is another factor that colours the German response. Berlin is only about 750 miles (1,200 km) from Ukraine's capital Kiev, roughly the distance between New York and Chicago.

Because of these close links, Berlin has greeted U.S. Secretary of State John Kerry's weekend threat of sanctions - visa bans, asset freezes and retaliatory trade steps - with studious silence. It quickly dismissed U.S. suggestions that Russia be booted out of the Group of Eight (G8) forum.

"The Americans are far away," said one top German diplomat, requesting anonymity. "They have a lot less to lose from an escalation of this crisis."

GEORGIA PRECEDENT

Still, Germany will face huge pressure to respond with more than just words if Russia presses into eastern Ukraine or tries to consolidate control of Crimea, the southern region of Ukraine which was part of Russia until 1954.

In many ways, the conflict is similar to the 2008 clash between Russia and Georgia over the breakaway pro-Russian regions of Abkhazia and South Ossetia.

The main difference is that back then, many in the German government blamed Georgia's President Mikheil Saakashvili for luring the Russians into conflict. This time around, it is hard to argue that anyone but Putin is to blame for the sending of Russian troops into Crimea.

As was the case in Georgia, German officials are deeply sceptical about the political leadership in Ukraine, complicating their calculus.

They fear that former Prime Minister Yulia Tymoshenko, released from prison last month when Yanukovich fell, may seek support among radical elements of the opposition in a run for the presidency, splitting the country yet again.

And there remains little appetite in Berlin for dangling the carrot of EU membership to Ukraine, a country that watchdog Transparency International called the most corrupt in Europe in its 2013 ranking.

"It was a weak EU offer that left the space for this crisis to erupt in the first place," said Speck, referring to the EU association agreement that Yanukovich rejected last year, kicking off the street protests that toppled him.

"That is part of the problem. The ambiguity towards Ukraine continues to be coloured by sensitivity to Russia." (Additional reporting by Andreas Rinke and Alexandra Hudson; Editing by Giles Elgood)

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